Recall that a lessor classifies a lease as follows:
1. Operating Lease. A lease that does not meet any of the criteria in Column A or does not meet both of the criteria in Column B of Exhibit 21-2.
2. Sales-type Lease. A sales-type lease results in a manufacturer’s or dealer’s profit (or loss) and meets one or more of the criteria in Column A and both the criteria in Column B of Exhibit 21-2.
3. Direct Financing Lease. A direct financing lease does not result in a manufacturer’s or dealer’s profit (or loss) and meets one or more of the criteria in Column A and both the criteria in Column B of Exhibit 21-2.
4. Leveraged Lease. A leveraged lease is a special three-party lease that is always consid- ered to be a direct financing lease. We discuss these leases briefly in the Appendix to this chapter.
We discuss the accounting method for each of the first three leases in the sections following Real Report 21-1.
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6 Account for a lessor’s operat- ing, direct financing, and sales-type leases.
EXHIBIT 21-5 Disclosure Requirements for Lessee: Operating and Capital Leases A. For operating leases having lease terms in excess of one year:
1. Future minimum rental payments required as of the date of the latest balance sheet presented, for each of the five succeeding fiscal years and in total.
2. The total of minimum rentals to be received in the future under noncancelable subleases.
B. For all operating leases, rental expense for each period.
C. For capital leases:
1. The gross amount of assets recorded under capital leases by major classes according to nature or function.
2. Future minimum lease payments for each of the five succeeding fiscal years and in total with separate deductions from the total (1) for the amount of executory costs included in the minimum lease payments, and (2) for the amount of the imputed interest required to reduce the net minimum lease payments to present value.
3. The total of minimum sublease rentals to be received in the future under noncancelable subleases.
4. Assets, accumulated depreciation, depreciation expense, and liabilities.
D. For all leases, a general description of the lessee’s leasing arrangements including the following:
1. The existence and term of renewal or purchase options and escalation clauses.
2. Restrictions imposed by lease agreements, such as those concerning dividends, additional debt, and further leasing.
Operating Lease (Lessor)
Under an operating lease, a lessor company leasing an asset to a lessee retains substantially all the risks and benefits of ownership.The lessor includes the leased asset, say equipment, on its balance sheet in a subsection of property, plant, and equipment entitled Plant and Equipment Leased to Others.11It also records depreciation on the leased asset and includes it on its income statement. The lessor usually pays executory costs and records the rental receipts as revenue when they become receivable.
Real Report 21-1 Wal-Mart Stores: Long-Term Lease Obligations
NOTE 9 (in part)
The Company and certain of its subsidiaries have long-term leases for stores and equip- ment. Rentals (including, for certain leases, amounts applicable to taxes, insurance, main- tenance, other operating expenses, and contingent rentals) under all operating leases were $1.2 billion, $1.1 billion, and $1.1 billion in 2005, 2004, and 2003, respectively.
Aggregate minimum annual rentals at January 31, 2005, under noncancelable leases are as follows (in millions):
Fiscal Operating Capital
Year Leases Leases
2006 $ 730 $ 521
2007 700 514
2008 626 505
2009 578 490
2010 530 468
Thereafter 5,908 3,222
Total minimum rentals $9,072 5,720
Less estimated executory costs 42
Net minimum lease payments 5,678
Less imputed interest at rates
ranging from 4.2% to 14.0% 1,886
Present value of minimum lease payments $3,792
Certain of the company’s leases provide for the payment of contingent rentals based on percentage of sales. Such contingent rentals amounted to $42 million, $46 million, and
$51 million in 2005, 2004, and 2003, respectively. Substantially all of the company’s store leases have renewal options, some of which may trigger an escalation in rentals.
The company has entered into lease commitments for land and buildings for 46 future locations. These lease commitments with real estate developers provide for minimum rentals ranging from 5–30 years, which if consummated based on current cost estimates, will approximate $30 million annually over the lease terms.
Questions:
1. Why do you think Wal-Mart has chosen to use long-term operating leases instead of buying the assets?
2. What is the present value of the minimum lease payments? Where would this be found on Wal-Mart’s balance sheet?
3. If Wal-Mart’s operating leases were classified as capital leases, what would the effect be on Wal-Mart’s debt ratio? For simplicity, assume that lease payments are made as a single annual payment at the beginning of each year. (On 1/31/05, Wal-Mart’s total liabilities were $70,827 million and its total assets were $120,223 million.)
11. Ibid., sec. L10.111.
C
Reporting
A
C
Reporting
A
Example: Operating Lease (Lessor) Assume that the Owner Company leases a piece of equipment to User Company for five years under the terms described in Example 21-1 on page 1073. User Company agrees to pay $50,000 at the beginning of each year. In addi- tion, the Owner Company purchased the equipment at a cost of $300,000. The equipment has an estimated life of 10 years and Owner Company uses the straight-line method of depreciation. On January 10, 2007 Owner pays the annual insurance premium of $2,000, and on December 15, 2007 it pays for repairs of $1,500. Assume that there are no initial direct costs involved in this lease. Owner records the preceding information as follows:
1. Purchase of Equipment to Be Leased on January 1, 2007
Equipment Leased to Others 300,000
Cash (or Accounts Payable) 300,000
We show the purchase of the equipment to reinforce your understanding of its clas- sification. If the company already owned the equipment, in the preceding entry it would credit the Equipment account, and also would reclassify the related Accumulated Depreciation.
2. Collection of Annual Payment on Operating Lease on January 1, 2007
Cash 50,000
Rental Revenue 50,000
Owner Company collects the annual rental payments at the beginning of each year and records them as revenue. If the amount is receivable at this date but not yet col- lected, Owner debits a Rent Receivable account. If Owner prepares monthly or quarterly interim statements, it reports the unearned portion of the preceding rev- enue as a liability, Unearned Rent.
3. Payment of Annual Insurance Premium on January 10, 2007
Insurance Expense 2,000
Cash 2,000
Under operating leases, the lessor usually pays executory costs such as insurance.
It records these costs as operating expenses and matches them against the gross rental revenue.
4. Payment of Repairs on December 15, 2007
Repair Expense 1,500
Cash 1,500
The repair expense is another example of an executory cost paid by the lessor.
5. Recognition of Annual Depreciation Expense on December 31, 2007 Depreciation Expense: Equipment Leased
to Others 30,000
Accumulated Depreciation: Equipment Leased
to Others 30,000
The lessor records depreciation on the leased equipment over its 10-year economic life. It reports the leased equipment and the accompanying accumulated deprecia- tion on its balance sheet. ♦
Initial Direct Costs Involved in an Operating Lease
In the preceding lease example, we assumed that there were no initial direct costs. Initial direct costs are costs that a lessor incurs directly from originating a lease that it would not have incurred if it had not entered into the lease contract. For an operating lease, the lessor records these costs as an asset and allocates them as an operating expense in propor- tion to the rental receipts over the term of the operating lease. This procedure results in an appropriate matching of the initial direct costs as an expense against the rental revenue.
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Conceptual
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Direct Financing Leases (Lessor)
Under a direct financing lease, the lessor is usually a financial institution (or a financial subsidiary of a company). The lessor “sells” the asset at a fair value equal to its cost or carrying value and records an accompanying receivable. Since there is no manufac- turer’s or dealer’s profit (or loss) in a direct financing lease, the net amount at which the lessor records the receivable must be equal to the cost or carrying value of the property.Thenetreceivable is equal to the present value of the future lease payments to be received. There are, however, two components of the net receivable (net invest- ment). These are the gross receivable (the total undiscounted cash flows) and the unearned interest(the interest to be earned over the life of the lease). The gross receiv- able of the lessor includes the sum of12
1. The undiscountedminimum lease payments to be received by the lessor, plus 2. Any unguaranteed residual value accruing to the benefit of the lessor.
Note that the gross receivable excludes any executory costs paid by the lessor.
However, it includes the residual value, whether guaranteed or unguaranteed. If the residual value is guaranteed, it is included in the minimum lease payments. If it is unguaranteed, it is explicitly included as the second item. The lessor records the dif- ference between the gross receivable (the Lease Receivable13account) and the cost or carrying value of the leased property as unearned revenue, with a title such as Unearned Interest: Leases. This account is a contra account and the lessor deducts this account from the Lease Receivable account to determine its net investment in the direct financing lease. The lessor reports this net investment on its balance sheet and divides the amount between the current and noncurrent asset sections. The current asset portion is determined by using the present value of next year’s payments approach or by using the change in present value approach, as we explained earlier for the lessee’s accounting.
Note that the lessor’s accounting according to FASB Statement No. 13 as Amended follows the “gross” method whereas, as we discussed earlier, the lessee’s follows the
“net” method. It is acceptable, however, for the lessor to record the asset at the “net”
amount, provided it makes the appropriate disclosures, as we show later. However, the main advantage of recording the receivable at the gross (undiscounted) amounts is that this accounting provides the information for the required disclosures, as we discuss later.
The lessor determines its interest revenue each period using the effective interest method to produce a constant periodic rate of return on the net investment in the lease.
At the beginning of the lease, the net investment is equal to the original cost of the asset, if it is new, or the carrying value, if it has been owned in previous periods. The interest rate implicit in the lease is the rate that, when applied to the gross receivable, will discount that amount to a present value that is equal to the net receivable.Thus, there are three variables: the present value (the net receivable), the implicit rate, and the future cash flows (the gross receivable). If the lessor knows two of these three variables, it can calculate the third. We show three examples of accounting for a direct financing lease in the following sections.
12. Ibid., sec. L10.114.
13. The title “Minimum Lease Payments Receivable” is appropriate when there is a guaranteedresidual value.
The title “Gross Investment in the Lease” is most appropriate if there is an unguaranteedresidual value, because then the lessor has not “sold” the residual value. For simplicity, we use the title “Lease Receivable.”
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Reporting
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Example: Direct Financing Lease with No Unguaranteed Residual Value and Payments Made at End of Year
For the first example, we show the accounting by the Gardner Leasing Company (a finan- cial institution) that leases equipment to the Martin Company as shown earlier in Example 21-3 on page 1077. In addition to the items in Example 21-3, assume that:
1. The collectibility of the lease payments is reasonably assured, and there are no uncertainties involved in the lease.
2. There are no initial direct costs of negotiating and closing the lease transaction.
The cost, and fair value, of the equipment is $100,000. The interest rate implicit in the lease is 12% on the net investment. Though given in the data for the lessee, the lessor cal- culates the annual rental payments it charges the lessee as follows:
Present Value Equal to the Cost of Equipment Annual Payments
Present Value of an Annuity for 4 Periods at 12%
$100,000 3.037349 $32,923.45
As we show in Example 21-7, based on the criteria from Exhibit 21-2 (columns A and B) the lease is a direct financing rather than a sales-type lease because the fair (present) value of the property is equal to its cost.
The lessor records the Lease Receivable at the sum of the undiscounted annual payments to be collected from the lessee plus the undiscounted unguaranteed resid- ual value. Since there are no executory costs or unguaranteed residual value, the Gardner Leasing Company records this asset at $131,693.80 {[4 ($32,923.45 $0)] $0}.
The beginning balance of the account, Unearned Interest: Leases, is the difference between the Lease Receivable account and the cost or carrying value of the leased asset.
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EXAMPLE 21-7 Application of Lease Classification Criteria by Gardner Leasing Company (Lessor)
Classification Criteria Criteria Met? Remarks
Column A
1. Transfer of ownership No
2. Bargain purchase option No
3. Lease term is 75% or more of economic life Yes 100% of economic life 4. Present value of minimum lease payments is 90%
or more of fair value Yes The present value is
$100,000, or100%
of fair value Column B
1. Collectibility reasonably assured Yes
2. No uncertainties Yes
Decision:If the lease meets one or more of the Column A criteria and both of Column B criteria, and there is no manufacturer’s or dealer’s profit or loss, it is a direct financing lease.
Conclusion:The lease is a direct financing lease, since appropriate criteria are met and there is no manufacturer’s or dealer’s profit or loss. The present (fair) value of the lease payments equals the
For the Gardner Leasing Company, this difference is $31,693.80 ($131,693.80
$100,000). Gardner records the following for 2007 and 2008:
1. Initial Recording of the Lease on January 1, 2007
Lease Receivable 131,693.80
Equipment 100,000.00
Unearned Interest: Leases 31,693.80
The effect of this transaction is to replace the equipment asset with a monetary asset of an equal amount. Again, note that Gardner records the receivable at the amount of the gross (undiscounted) rentals plus the estimated unguaranteed residual value of the leased asset (zero in this case). It credits the Equipment account for the cost of the item, because from an economic-substance-over-legal-form point of view it is the disposal of an asset, even though legal transfer of ownership has not occurred. Gardner records the Unearned Interest: Leases account as the dif- ference between the cost of the equipment and the receivable; it is a contra account to the Lease Receivable account.
2. Collection of Annual Payment at End of First Year on December 31, 2007
Cash 32,923.45
Lease Receivable 32,923.45
Gardner collects and records the payment of $32,923.45.
3. Recognition of Interest Revenue for First Year on December 31, 2007
Unearned Interest: Leases 12,000.00
Interest Revenue: Leases 12,000.00
Gardner amortizes the Unearned Interest account using the effective interest method. That is, it recognizes the interest revenue as 12% of the net investment at the beginning of the period (the January 1, 2007 balance of the Lease Receivable less the January 1, 2007 balance of the Unearned Interest: Leases) or $12,000.00 (12%$100,000; that is, $131,693.80 $31,693.80).
Gardner (the lessor) separates the receivable into its current and noncurrent portions for reporting the lease on its balance sheet. It calculates the current and noncurrent amounts of the Net Investment that it reports on its December 31, 2007 balance sheet as follows:
Current Noncurrent
Lease receivable $32,923.45 $65,846.90a
Unearned interest: leases (3,527.52) (16,166.27)b
Net investment $29,395.93 $49,680.63
a. 2 $32,923.45
b. [$32,923.45 ($32,923.450.797194)] [$32,923.45($32,923.450.711780)]
Note that the $29,395.93 current portion plus the $49,680.63 noncurrent portion sum to the $79,076.55 (with a $0.01 rounding error) total Net Investment on December 31, 2007 shown in Example 21-8.
4. Collection of Annual Payment for Second Year on December 31, 2008
Cash 32,923.45
Lease Receivable 32,923.45
Gardner records the receipt of the payment for the second period in the same way as during the first period.
5. Recognition of Interest Revenue for Second Year on December 31, 2008
Unearned Interest: Leases 9,489.19
Interest Revenue: Leases 9,489.19
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Conceptual
The calculation of the 2008 interest revenue by the effective interest method follows the same procedure as that for 2007. The only difference is that the net investment as of January 1, 2008 is less than that of January 1, 2007. The cal- culation for 2008 is 12% of the January 1, 2008 balance in the Lease Receivable account less the January 1, 2008 balance of the Unearned Interest: Leases. For 2008 the interest revenue is $9,489.19 (12% $79,076.55; that is, $100,000
$20,923.45).
Example 21-8 shows the interest revenue and the reductions in the receivable and the unearned interest over the life of the lease. The Gardner Leasing Company would use the information we show in Example 21-8 to record the journal entries for the remaining years of the lease. At the end of 2008 its net investment is zero. ♦
Example: Direct Financing Lease with No Unguaranteed Residual Value and Payments Received in Advance
To show a direct financing lease with a different timing of the payments, assume that on January 1, 2007 the Watkins Finance Company leases equipment to the Hutton Company, with the terms and provisions of the lease we show in Example 21-9. This lease is a direct financing lease because the provisions of the lease agreement we show in Example 21-9 meet one or more of the Column A and both of the Column B classifica- tion criteria from Exhibit 21-2, do not include any manufacturer’s or dealer’s profit, and the fair (present) value of the property is equal to its cost.
The Watkins Finance Company records the information for this lease in 2007 using the amounts from Example 21-10.
1. Initial Recording of Lease on January 1, 2007
Lease Receivable 500,000.00
Equipment 391,371.20
Unearned Interest: Leases 108,628.80
Watkins (the lessor) records the Lease Receivable at the undiscounted five annual rental payments totaling $500,000 (5 $100,000) plus the unguaranteed resid- ual value ($0 in this case). It records the Unearned Interest at $108,628.80. Thus, the net receivable is the cost of the equipment of $391,371.20. Because the trans- action is considered a disposal of an asset, Watkins also credits Equipment.
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EXAMPLE 21-8 Summary of Lease Payments Received in Arrears and
Interest Revenue Earned by Gardner Leasing Company ( Lessor)
(1) (2) (3) (4) (5) (6) (7)
Annual Interest Amount
Lease Revenue at of Net Unearned
Payment 12% on Net Investment Lease Interest Net
Date Received Investmenta Recoveredb Receivablec Leasesd Investmente
January 1, 2007 $131,693.80 $31,693.80 $100,000.00
December 31, 2007 $32,923.45 $12,000.00 $20,923.45 98,770.35 19,693.80 79,076.55 December 31, 2008 32,923.45 9,489.19 23,434.26 65,846.90 10,204.61 55,642.29
December 31, 2009 32,923.45 6,677.07 26,246.38 32,923.45 3,527.54 29,395.91
December 31, 2010 32,923.45 3,527.54f 29,395.91 0 0 0
a. Column 7 at beginning of year 12%
b. Column 2 Column 3
c. Annual lease payment Number of years remaining on lease, or Previous balance Column 2 d. Previous balance Column 3
e. Column 5 Column 6 f. Adjusted for $0.03 rounding error
2. Collection of Annual Payment for First Year on January 1, 2007
Cash 100,000.00
Lease Receivable 100,000.00
The payments are collected in advance. The first payment collected consists entirely of principal since no interest has accrued. (The two preceding journal entries could be made as one compound entry.)
EXAMPLE 21-9 Terms and Provisions of Lease Agreement Between Watkins Finance Company (Lessor) and Hutton Company (Lessee) Dated January 1, 2007 1. The cost, and fair value, of the equipment is $391,371.20.
2. The initial direct costs incurred by Watkins Finance Company are not material.
3. The term of the lease is five years, with annual payments of $100,000 received in advance at the beginning of each year.
4. The economic useful life of the equipment is five years and the estimated residual value to the lessor is zero.
5. The lease receipts are determined at an amount that will yield to the Watkins Finance Company a 14% annual rate of return on net investment.
6. The Hutton Company pays all the executory costs.
7. The equipment reverts to the Watkins Finance Company at the end of the fifth year; the lease contains no bargain purchase option.
8. The present value of the minimum lease payments receivable for the lessor is $391,371.20, calculated as follows:
Present value of 5 amounts of
3.913712 $100,000
$100,000 in advance at 14%
$391,371.20
9 . The collectibility of the payments is reasonably assured, and there are no uncertainties involved in the lease.
EXAMPLE 21-10 Summary of Lease Payments Received in Advance and Interest Revenue Earned by Watkins Finance Company (Lessor)
(1) (2) (3) (4) (5) (6)
Interest
Annual Lease Revenue at Unearned
Payment 14% on Net Lease Interest:
Date Received Investmenta Receivableb Leasesc Net Investmentd
January 1, 2007 $500,000 $108,628.80 $391,371.20
January 1, 2007 $100,000 400,000 291,371.20
December 31, 2007 $40,791.97 67,836.83 332,163.17e
January 1, 2008 100,000 300,000 232,163.17
December 31, 2008 32,502.84 35,333.99 264,666.01e
January 1, 2009 100,000 200,000 164,666.01
December 31, 2009 23,053.24 12,280.75 187,719.25e
January 1, 2010 100,000 100,000 87,719.25
December 31, 2010 12,280.75f 0 100,000.00e
January 1, 2011 100,000 0 0
a. Column 6 at beginning of year 14%
b. Annual lease payment Number of years remaining on lease, or Previous balance Column 2 c. Previous balance Column 3
d. Column 4 Column 5
e. $100,000 of this amount is a current asset; it will be received on January 1 of the next year. The remaining amount is a noncurrent asset.
f. Adjusted for $0.05 rounding error